Financial Intermediaries

Question 1

Problems with direct funding

Answer 1

Mismatch of preferences
- Lenders, small amount
- Borrowers, large amount
Consequence - reduces probability of the success of a transaction

Transaction Costs (directly incurred)

• searching
• valuation and verification
• monitoring
• enforcement

Information asymmetry
- adverse selection -worse types remain in the market
- Moral hazard - moral element; promise not kept
Solution - reduce info asymmetry, remove choice

Question 2

Gains from intermediation

Answer 2

Reconcile preference mismatch
Aggregate small deposits - size, risk, maturity

Reduce direct transaction costs in each stage of transaction. Cost reduction achieved via specialisation, experiences and economies of scale

Reduce Asymmetry
Generate information
- Banks have no free rider problem
- Banks able to collect information

Reduce averse selection by requesting collaterals
reduce moral hazard by imposing strict debt covenants

Question 3

Delegated Monitoring theory

Answer 3

Banks do not need monitoring because;

• bank monitoring more efficient than depositor motoring
• Banks very unlikely to default